The Impact of Minimum Wages on Wage Inequality and Employment in the Formal and Informal Sector in Costa Rica

William Davidson Institute Working Paper 479

1. INTRODUCTION

Minimum wage policies have always been controversial among economists and policy
makers and the debate has become more heated following the recent publication of the book by
Card and Krueger (1995) and related papers (e.g., Katz and Krueger, 1992; Card and Krueger,
1994). Supporters of minimum wages justify them as a way of improving the living conditions of
the poor, unskilled, unorganised workers. Critics emphasize the efficiency losses associated with
their use, and disqualify them as an adequate way of affecting inequality. They argue that in
developing countries minimum wages are the principal source of labour market segmentation
and unemployment.

The traditional view, using the standard two-sector model which assumes a perfectly
competitive labour market with homogeneous and mobile labour, is that an increase in the
minimum wage, reduces employment in the covered sector, creates unemployment, and has
“negative” spillover effects in the uncovered sector (i.e., increasing employment there and
putting downward pressure on wages at the lower end of the distribution).¹ Hence increasing the
minimum wage should increase income inequality in the uncovered sector and reduce it in the
covered sector.

On the other hand if minimum wages do not reduce employment in the covered sector
and hence have no spillover effects (the outcome in a monopsonistic model of the labour
market), changes in minimum wages will not have an efficiency loss and may not effect wage
inequality in the uncovered sector.² If employment actually increases in the covered sector as a
result of minimum wage increase, and draws low wage workers from the uncovered sector, then
one might expect earnings inequality to fall in the uncovered sector. Until the Card and Krueger
(1994, 1995) and related research, which found a positive effect of the minimum wage on

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